The prospect of massive fiscal stimulus promised by the Trump administration had been greeted with a lot of enthusiasm by investors at the end of last year, but some strategists believe policy mistakes are likely to hurt bond and equity markets rather than help them.

David Kelly, global investment strategist at JPMorgan Funds, in an interview with MarketWatch said borrowing money for infrastructure spending and simultaneously cutting income and corporate taxes will push up inflation without spurring economic growth.

“It has been argued that this fiscal stimulus, along with deregulation, will spur more economic growth and that this economic growth will expand the tax base, paying for much of the cost of the stimulus,” said Kelly. “But a basic law of macroeconomics states that an economy at full employment can only grow in line with increases in productivity and labor supply.”

The May unemployment rate at 4.3% was the lowest since 2001. The next official monthly jobs report is due out July 7, with economists expecting 138,000 news jobs created in June, likely keeping the unemployment rate at the same low level.

After the Federal Reserve raised interest rates by a quarter of a percentage point on June 14, Fed Chairwoman Janet Yellen during the news conference said that the labor market at full employment does not need fiscal stimulus. Yellen suggested that government should instead focus on budget actions that would boost productivity and thus the long-term performance of the economy.

Despite years of ultraloose monetary policy with interest rates near zero, gross domestic product growth—the broadest measure of economic strength—has hovered near a lukewarm 2% rate over the course of the expansion.

Kelly agrees with Yellen on the usefulness of fiscal stimulus but goes further. He suggests it might actually harm the markets.

“A dangerous ignorance of macro-economic laws is tempting us to spend money we don’t have on stimulus we don’t need and which can’t actually stimulate real output in any significant way, with particularly negative consequences for the bond market,” Kelly said.

‘The first few rate hikes normally don’t hurt stocks, as investors see it as confidence in the economy. But it will push asset allocation from bonds to stocks, pushing valuations even higher.’
David Kelly

The issue, he says, is not just higher inflation but that overstimulation at full employment can create asset bubbles, with both equities and real estate particularly vulnerable at this stage.

“The first few rate hikes normally don’t hurt stocks, as investors see it as confidence in the economy. But it will push asset allocation from bonds to stocks, pushing valuations even higher. But as borrowing costs rise because the Fed is now more hawkish, stock prices will fall. And the higher the valuation, the bigger the correction will be once investors lose confidence,” Kelly said.

The S&P 500
SPX, -1.54%
on Tuesday was trading at 2,438, less than a percentage point below its all-time high set last week. Meanwhile, the cyclically adjusted price-to-earnings ratio, better known as CAPE and developed by Yale’s Robert Shiller, is currently at 29. It has been higher only twice before: in 1929, when it hit 32.5, and in 2000, when it hit 44 at the height of the dot-com bubble. The long-term average is about 16.

Treasury bond
TMUBMUSD10Y, +0.64%
prices have also been rallying since December, with the yield on the 10-year note at 2.19%, hovering near the lowest levels since last November and somewhat contradicting the Fed’s efforts to remove stimulus by raising borrowing costs.

Given the potential for policy mistakes, Kelly said investors should have a sober perspective on returns from financial markets.

“Within equities, it is better to be overweight international or cyclical stocks, such as financials and technology, with the latter trading at much higher valuations,” Kelly said.

“Within fixed income, higher-duration bonds will be more volatile as rates go up, so shortening duration is more prudent,” he added.

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